By Laura Elisa Leal, M.B.A. & Edson Timana, M.A.
The old saying that “history tends to repeat itself” is a well suited phrase for studying economic theories and institutions. Economic history, at least in the United States, demonstrates that fluctuations are a normal aspect of the boom-bust cycle. Everyone expects these fluctuations to happen and these corrections are vital to sustaining an open market system. When these market corrections occur (think 1929 or 2008), they can significantly impact prices, production levels, interest rates and the stock market. At times, these fluctuations become so severe and prolonged that people are compelled to do a close-up review of market structures and the instability that seems to be deeply rooted in both financial and investment paradigms. One would think that US markets would tend to shield themselves from such instability—that certain gates or walls (taken in the form of regulations, policies, and institutional intervention) could be strategically placed so as to minimize damage to US financial markets and increase the overall feeling of economic well-being.
In our more recent experience with financial/economic instability, we realized that economic growth (marked notably by increases in real GDP) can be terribly undermined by irrational valuation of assets and greater leniency towards leveraged borrowing, thus leading to what is commonly regarded as a balance sheet recession. The dangers of this type of recession is debt-deflation and systemic failure which ultimately leads to the trade-off of financial/economic destabilization…and once the pieces are picked up is doomed to be repeated yet again.
Hyman Minsky (1919-1996) was a keen observer of this recurring phenomenon. His observations on boom-bust business cycles laid the groundwork for his Financial Instability Hypothesis, thereby asserting a fresh perspective for explaining persistent destabilization forces found at both the business and macroeconomic levels. For decades, he asserted that “[t]he conclusions based on the models derived from standard theoretical economics cannot be applied to the formulation of policy for our type of economy…the model does not deal with time, money, uncertainty, financing of ownership of capital assets, and investments”(Minsky,1986).
To describe Minsky’s ideas more succinctly, macroeconomic stabilization would require that economic agents (primarily banks and government) be viewed as “cash inflow-outflow entities, facing solvency and liquidity survival constraints” and that these agents should exercise greater discretion when faced with the temptation of “financing long lived capital assets with short-term debt and rolling the debt at maturity into another short-term debt” (Mehrling, 2015). This affirms Minsky’s distrust of speculative and Ponzi financing and its destructive effects on the domestic economy and global markets. This is not to state, however, that all financing mechanisms should be constrained, but rather that short term financing should be used sparingly to finance long term projects due to the volatile nature of current financial markets (for instance, political events such as the Brexit vote or the use of negative interest rates in Europe/Japan clearly affirm that liquidity/credit is a global problem and that partially explains why there is a greater rate of volatility and market distortions).
In summary, Minsky believed that market destabilization could be mitigated by implementing the following recommendations:
1) Better cash flow examination procedures…in other words, there should be greater transparency between the Federal Reserve, member banks and fringe banks.
2) Extending access to the Federal Reserve’s discount window to primary securities dealers and important financial intermediaries
3) Carefully examining all financial institutions, and in particular those financial institutions that can be characterized as fringe banks such as real estate investment trusts, finance companies, government bond dealers, commercial paper houses and any other institution engaged in position making…the Federal Reserve must be aware of how these fringe banks finance their own operations and the extent to which commercial banks provide both the ‘normal’ finance and the ‘fall back’ financing for fringe bank institutions” (Kregel, 2010).
Minsky’s ideas about destabilizing market forces and how to address them open up readers into an intriguing world of finance, price theory and monetary/fiscal policies. Although his viewpoints are not altogether orthodox, Minsky’s work does in fact support some key underpinnings found in neoclassical Keynesian theory and at best, helps to explain how financial markets and economics leave their mark on political, social and legal institutions throughout the world. The aforementioned Minsky reforms could serve as reliable “monetary stabilizers” and thereby help economies to “normalize” and attain their target rates in both inflation and employment.
References
Kregel, J. (2010). Minsky Moments and Minsky’s Proposals for Regulation of an Unstable Financial System. Presented at 19th Annual Hyman P. Minsky Conference, Bard College. Mehrling, P.G. (2015, 30 September). Minsky’s Financial Instability Hypothesis and Modern Economics. [Weblog]. Retrieved 9 June, 2016], from: http://www.perrymehrling.com/ Minsky, H. P. (1986). Stabilizing an Unstable Economy. New York, NY: McGraw Hill Professional.